Investment: Objective, Process, Types, Investment Risks

  • Post last modified:23/11/2021
  • Reading time:17 mins read

What is Investment?

An investment is an asset or item acquired with the goal of generating income or appreciation. Appreciation refers to an increase in the value of an asset over time. When an individual purchase a good as an investment, the intent is not to consume the good but rather to use it in the future to create wealth.

An investment always concerns the outlay of some asset today time, money, or effort in hopes of a greater payoff in the future than what was originally put in. Investment does not always guarantee higher returns but at times we also incur losses, the investment environment is quite uncertain.

We are in fact facing VUCA (votality, uncertainty, complex, ambiguous) environment in the context of investment For example: in 1986 Microsoft corporation offer its first stock and in 10yr it has grown 5000% on the other hand worlds of wonder also offer stock in the same yr. and 10yr later the company become defunct.


Objective of Investment

A person makes the investment in order to accomplish a certain objective. People forego current consumption in order to avail themselves of higher returns. the ultimate objective of the investment is to minimize risk and maximize return. Nothing can be risk-free in this world, risk and return go hand in hand, the higher the risk higher will be return.

Some of the objectives that are kept in mind before making an investment are as follows:

  1. Capital Appreciation
  2. Current Income
  3. Capital Preservation
  4. Speculation
Objective of Investment
Objective of Investment

Capital Appreciation

Capital appreciation is concerned with long-term growth and is most common in retirement plans where investments work for many years inside a qualified plan, such as a 401(k) or IRA. However, investing for capital appreciation is not limited to qualified retirement accounts. This objective involves holding stocks for many years and letting them grow within your portfolio while reinvesting dividends to purchase more shares.

For example: Let’s imagine that you make an initial $1,000 investment and add $100 monthly for the next 20 years. The total amount contributed during that period would be $25,000. However, if your investments generate an 8% return annually, compound interest will place your total savings at $59,575.31.

Investors using the capital appreciation strategy are not concerned with day-to-day fluctuations. However, they keep a close eye on the fundamentals of the company for changes that could affect long-term growth. A typical strategy involves regular purchases.

Current Income

The current income involves investing in stocks that pay a consistent and high dividend, as well as some top-quality real estate investment trusts (REITs) and highlyrated bonds because these products produce regular current income.

People concerned with current income should consider investing in blue-chip stocks, which are shares in large, prominent corporations that have shown a long history of growth and consistent dividend payouts. Many people who focus on current income are retired and use the income for living expenses.

In contrast, others take advantage of a lump sum of capital to create an income stream that never touches the principal, yet provides cash for certain current needs such as college tuition.

Capital Preservation

Capital preservation is often associated with retired or nearly retired people who want to make sure they don’t outlive their money. For this investor, safety is critical—even if it involves giving up return potential for security. The logic for this safety is clear: A retiree who loses money through unwise investments is unlikely to get a chance to replace it.

Younger investors can have a stock-dominated portfolio because they have many years to recover from any losses that may occur due to market changes or economic downturns. This isn’t the case for older individuals. Investors who want capital preservation tend to invest in bank CDs, U.S. Treasury issues, and savings accounts because they offer modest returns but possess much less risk than stocks.

Speculation

The speculator is not a true investor, but a trader who enjoys jumping in and out of stocks for capital gain. Speculators or traders are interested in quick profits and use advanced trading techniques like shorting stocks, trading on the margin, options, and other special methods.

Speculators have no real attachment to the companies they trade, and they may not know much about the underlying business except that the stock is volatile and ripe for a quick profit. Many people try speculating in the stock market with the misguided goal of getting rich, and the overwhelming majority fail at doing so.

If you want to try your hand, make sure you are using the money you can afford to lose without jeopardizing your livelihood or retirement ambitions. It’s easy to get a false sense of competence after initial success, so thoroughly understand the real possibilities of losing your investment.

However excessive speculation is bad as it takes away from their true fundamental values. Therefore, SEBI keeps checking on excessive speculation under SEBI act 1992.


Process of Investment

Knowledgeable investing requires the investing to be aware of his needs the amount of money he can invest and the investment options available to him. These will relate to the investment decision process.

A typical investment decision goes through a five-step procedure which is known as the investment process these steps are:

  1. Defining Investment Objective
  2. Analyzing Securities
  3. Construct a Portfolio
  4. Evaluate the Performance of Portfolio
  5. Review the Portfolio
Process of Investment
Process of Investment

Defining Investment Objective

Investment objectives may vary from person to person .it should be stated in terms of both risk and return. In other words, the objective of an investor is to make money by accepting the fact of risks that are likely to happen.

The typical objectives of investors include the current income, capital appreciation, and safety of principal. Moreover, constraints arising due to liquidity, the time horizon, tax and other special circumstances, if any must also be considered These steps of the investment process also identify the potential financial assets that may be included in the portfolio based on the investment objectives.

Analyzing Securities

The second steps of analyzing securities enable the investor to distinguish between underpriced and overpriced stock. Return can be maximized by investing in stocks that are currently underpriced but have the potential to increase.

It might be useful to remember the golden principle of investment; buy low sell high. There are two approaches used for analyzing securities; technical analysis and fundamental analysis.

Construct a Portfolio

The actual construction of a portfolio, which can be divided into three sub parts:

  1. How to allocate the portfolio across different asset classes such as equities, fixed income securities and real assets.

  2. The assets selection decision, this is the step where the stocks make up the equity component, the bonds that make up the fixed income component.

  3. The final component is execution, where the portfolio is actually put together, where investors have to trade off transaction cost against transactionspeed.

Evaluate the Performance of Portfolio

The performance evaluation of the portfolio is done in terms of risk and return. Evaluation measures are to be developed. CAGR(compounded annual growth rate) may be one criterion. Hindustan Unilever gave a CAGR of 21 percent in returns to the shareholders for the last 13 years.

Review the Portfolio

It involves the periodic repetition of the above steps. The investment objective of an investor may change over time and the current portfolio may no longer be optimal for him. so the investor may form a new portfolio by selling certain securities and purchasing others that are not held in the current portfolio.


Types of Investments

Following are types of investments which are given below:

  1. Deposits
  2. Tax Sheltered Saving Scheme
  3. Life Insurance
  4. Mutual Fund
  5. Real Estate
  6. Commodities
  7. Gold
  8. Silver
Types of Investments
Types of Investments

Deposits

Deposits earn fixed rate of return. Even though bank deposits resemble fixed-income securities they are not negotiable instruments. Some of the deposits are dealt with subsequently:

  1. Bank Deposits
  2. Post Office Deposits
  3. NBFC Deposits

Bank Deposits

It is the simplest investment avenue open for investors. He has to open an account and deposit the money. Traditionally the banks offered a current account, Saving account and fixed deposits account. The current account does not offer any interest rate. The drawback of having a large amount in saving accounts is that the return is just 4 percent.

The saving account is more liquid and convenient to handle. The fixed account carries a high-interest rate and the money is locked up for a fixed period. With increasing competition among the banks, the banks have handled the plain saving account with the fixed account to cater to the needs of the small savers.

Post Office Deposits

The post office also offers fixed deposit facility and a monthly income scheme. A monthly income scheme is a popular scheme for the retired, an interest rate of 9 percent is paid monthly. The term of the scheme is 6 years, at the end of which a bonus of 10 percent is paid.

The annualized yield to maturity works out to be 15.01 per annum, after three years, premature closure is allowed without any penalty. if the closure is one year, a penalty of 5 percent is charged.

NBFC Deposits

n recent years there has been a significant increase in the importance of non-banking financial companies in the process of financial intermediation. The NBFC come under the purview of the RBI. The Act in January 1997, made registration compulsory for the NBFCs:

  1. Period the period ranges from few months to five years.

  2. Maximum limit the limit for acceptance of deposit has been on the creditrating of the company.

  3. Interest NBFCs have been debarred from offering an interest rate exceeding 16% per annum and a brokerage fee over 2% on public deposit. The interest rate differs according to maturity period.

Tax Sheltered Saving Scheme

The important tax-sheltered saving scheme is:

  1. Public Provident Fund Scheme (PPF)
  2. National Saving Scheme (NSS)
  3. National Saving Certificate

Public Provident Fund Scheme (PPF)

PPF earn an interest rate of 8.5% per annum compounded annually. Which is exempted from the income tax under sec80 C. The individuals and Hindu undivided families can participate in this scheme. There is a lock-in period of 15years. PPF is not intended for those who are liquidity and short term returns. at the time of maturity, no tax is to be given.

National Saving Scheme (NSS)

National saving scheme(NSS): This scheme helps in deferring the tax payment. Individuals and HUF are eligible to open NSS account in the designated post office.

National Saving Certificate

This scheme is offered by the post office. These certificates come in the denomination of Rs.500,1000,5000 and 10000. The contribution and the interest for the first five years are covered by sec 88. The interest is cumulative at the rate of 8.5%per annum and payable biannually is covered by sec 80 L.

Life Insurance

Life insurance is a contract for payment of a sum of money to the person assured on the happening of the event insured against. Usually, the contract provides for the payment of an amount on the date of maturity or at a specified date or if unfortunate death occurs.

The major advantage of life insurance is given below:

  1. Protection saving through life insurance guarantees full protection against risk of death of the saver. The full assured sum is paid, whereas in other schemes only the amount saved is paid.

  2. Easy payments for the salaried people the salary saving schemes are introduced. Further there is an installment facility method of payment through monthly, quarterly, half yearly or yearly mode.

  3. Liquidity loans can be raised on the security of the policy.

  4. Tax relief tax relief in income tax and wealth tax is available for amounts paid by way of premium for life insurance subject to the tax rates in force.

Type of Life Insurance Policy

  • Endowment policy: The objective of this policy is to provide an assured sum, both in the event of the policy holders’ death or at the expiry of the policy.

  • Term policy: In a term policy investor pays a small premium to insure his life for a comparatively higher value. The objective behind the scheme is not to get any amount on the expiry of the policy. But simply to ensure the financial future of the investors dependents.

  • Whole life policy: It is a low cost insurance plan where the sum assured is payable on thedeath of the life insured and premium are payable throughout life.

  • Money back policy: The insurance company pays the sum assured at periodical intervals to the policy holder plus the entire sum assured to the beneficiaries in case of the policy holders demise before maturity.

  • ULIPs: Unit Linked Insurance Policies are a combination of mutual fund and life insurance. Investments in ULIPs have two component-one part is used as a premium for life insurance while the other part acts s the investment fund.

    The investment component works exactly like mutual fund money is invested in stocks, bonds; government securities etc., an investor receive money in return.

Mutual Fund

Investing directly in equity shares, and debt instruments may be a difficult task for a large number of customers because they want to know more about the company, promoter, prospects, competition for the product etc. In such a case, investors can go for investing in financial assets indirectly through a mutual fund.

A mutual fund is a trust that pools the savings of a number of investors who share a common financial goal. Each scheme of a mutual fund can have different character and objectives.

Type of Mutual Funds

  • Open ended schemes: In this scheme there is an uninterrupted entry and exist into the funds. The open ended scheme has no maturity period and they are not listed in the stock exchanges. The open ended fund provides liquidity to the investors since repurchase available.

  • Closed ended funds: The closed ended funds have a fixed maturity period. The first time investments are made when the close ended scheme is kept open for a limited period. Once closed, the units are listed on a stock exchange .investors can buy and sell their units only through stock exchanges.

  • Growth scheme: aims to provide capital appreciation over medium to long term. Generally these funds invest their money in equities.

  • Income scheme: aims to provide a regular return to its unit holders. Mostly these funds deploy their funds in fixed income securities.

Real Estate

The real estate market offers a high return to investors. The word real estate means land and buildings. There is a normal notion that the price of real estate has increased by more than 12% over the past ten years. Real estate investments cannot be enchased quickly. Liquidity is a problem.

Real estate investment involves high transaction costs. The asset must be managed, i.e. painting, repair, maintenance etc.

Commodities

Commodities have emerged as an alternative investment option nowadays and investors make use of this option to hedge against spiralling inflation- commodities may be broadly divided into three. Metals, petroleum products and agricultural commodities. Metals can be divided into precious metals and other metals. Gold and silver are the most preferred ones for beating inflation.

Gold

Off all the precious metals gold is the most popular as an investment. Investors generally buy gold as a hedge against economic, political, social fiat currency crises. Gold prices are soaring to new highs in recent years compared to the previous decades because whenever the signs of an economic crisis arises in the world markets may find shelter in gold as safest asset class for investors all around the world.

Silver

The yellow metal is treated as safe haven .but silver is used abundantly for industrial applications. Investment in silver has given investors, super returns than what gold has given.


Types of Investment Risk

The dictionary meaning of risk is the possibility of loss or injury; risk the possibility of not getting the expected return. The difference between expected return and actual return is called the risk in investment. Investment situation may be high risk, medium and low risk investment.

Following are the types of investment risks:

  1. Interest Rate Risk
  2. Market Risk
  3. Purchasing Power Risk
  4. Business risk
  5. Financial Risk
Types of Investment Risk
Types of Investment Risk

Interest Rate Risk

Interest rate risk is the variation in the single period rates of return caused by the fluctuations in the market interest rate. Most commonly the interest rate risk affects the debt securities like bond, debentures.

Market Risk

Jack clarkfrancis has defined market risk as that portion of total variability of return caused by the alternating forces of bull and bear market. This is a type of systematic risk that affects share .market price of shares move up and down consistently for some period of time.

Purchasing Power Risk

Another type of systematic risk is the purchasing power risk .it refers to the variation in investor return caused by inflation.

Business risk

Every company operates with in a particular operating environment, operating environment comprises both internal environment within the firm and external environment outside the firm. Business risk is thus a function of the operating conditions faced by a company and is the variability in operating income caused by the operating conditions of the company.

Financial Risk

It refers to the variability of the income to the equity capital due to the debt capital. Financial risk in a company is associated with the capital structure of the company. The debt in the capital structure creates fixed payments in the form of interest this creates more variability in the earning per share available to equity share holders .this variability of return is called financial risk and it is a type of unsystematic risk.


Difference Between Direct and Indirect Investing

Following are some basics of differences between direct and indirect investing explained below:

Difference Between Direct and Indirect Investing

BasisDirect InvestingIndirect Investing
MeaningDirect investing involves the purchase or sale of securities by the investors themselves.Indirect investing means investment in mutual funds or other investment companies rather directly in securities
Instruments of investmentCapital market such as equity, shares, bonds, debentures etc. Money market such as treasury bills, certificates of deposits, commercial paper etc. Derivative market such as future and option.Mutual funds -open-ended and close-ended. Exchange-traded funds Collective investment schemes Alternative investment funds-such as venture capital funds, hedge funds, ME funds, real estate investment trusts (REITs) etc
ControlThe investor has entire control over investment decisions i.e., which securities need to be purchased or sold.Fund or investment company has direct control over the investment decision i.e., which securities need to be purchased and sold as well as when to purchase or sell.
CostsThe cost of monitoring and analysis is born by investors directly.Cost is incurred by fund houses or investment company but they are ultimately transferred to investors in the form of the management fee.
Skills and TimeDirect investing requires investing skills and expertise. moreover, it is the time-consuming process of investing by the individual investorIndirect investing does not require investing skills and expertise by the individual investor. the fund or investment company where the investor invests is expected to provide such expertise and professional fund management. they have professional fund managers.
ConvenienceDirect investing may not be convenient to small investors who do not possess requisite investing skills and who do not have much time to perform security analysis.Indirect investing is the very convenient and preferred mode of investment to small investors who do not possess requisite investing skills and do not have much time to perform security analysis.
Difference Between Direct and Indirect Investing

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